What Life Insurance Can You Borrow Against?

Certain types of life insurance accumulate a cash value, which policyholders can access through loans. These policy loans offer a flexible way to obtain funds, using the policy’s accumulated value as collateral. This article clarifies the types of policies that allow borrowing and outlines the general mechanics and tax implications of such loans.

Types of Life Insurance with Cash Value

“Cash value” refers to a savings component that builds within certain permanent life insurance policies over time. This value accumulates from a portion of the premiums paid, growing on a tax-deferred basis. The cash value can then be accessed by the policyholder during their lifetime, making it the basis for a policy loan.

Whole life insurance is a permanent policy where the cash value grows on a guaranteed basis, offering predictable accumulation. Premiums typically remain fixed for the life of the policy, and the cash value provides a stable component that can be borrowed against.

Universal life insurance provides more flexibility in premium payments and death benefits compared to whole life. Its cash value component grows based on an interest rate set by the insurer, which may fluctuate but often includes a guaranteed minimum rate. This adaptability allows policyholders to adjust payments, potentially influencing the rate at which cash value accrues and becomes available for loans.

Variable universal life insurance ties its cash value growth to the performance of underlying investment sub-accounts. While this offers the potential for higher returns, it also involves investment risk, meaning the cash value can fluctuate with market performance. This type of policy permits borrowing against its cash value.

Term life insurance does not build cash value. It provides coverage for a specific period, such as 10, 20, or 30 years, and typically has lower premiums than permanent policies. Since there is no cash accumulation feature, term life insurance policies cannot be borrowed against.

The Mechanics of Borrowing from Your Policy

A loan from a life insurance policy is against its cash value, not a direct withdrawal. The accumulated cash value serves as collateral for the loan, and the policy remains in force, continuing to provide its death benefit and cash value growth. This structure allows the policyholder to access funds without liquidating the policy.

Interest is charged on the outstanding loan balance. Typical interest rates for policy loans often range from 5% to 8%, which can be lower than rates for personal loans or credit cards. This interest can be paid periodically, or it may be added to the loan balance, causing the total amount owed to increase over time.

Policy loans feature flexible repayment terms, meaning there is no fixed repayment schedule. Policyholders can choose to repay the loan at their discretion, or not repay it at all. However, any outstanding loan balance, including accrued interest, will be deducted from the death benefit paid to beneficiaries.

If the outstanding loan balance plus accrued interest exceeds the policy’s cash value, the policy could lapse, resulting in a loss of coverage. To access a loan, the policyholder contacts their insurance company, completes a request form.

Tax Implications of Life Insurance Loans

Policy loans from life insurance are not considered taxable income, provided the policy remains in force. This is because the transaction is viewed as a loan against an asset, rather than a distribution of gains.

An exception applies to policies classified as Modified Endowment Contracts (MECs). A policy becomes an MEC if the premiums paid exceed certain limits set by tax law, typically the “7-pay test,” within the first seven years. For MECs, loans are subject to “last-in, first-out” (LIFO) tax rules, meaning any loan amount is first considered taxable gain to the extent of policy earnings. If the policyholder is under age 59½, a 10% penalty tax may apply to the taxable portion of the loan.

A tax consequence can arise if a policy with an outstanding loan lapses or is surrendered. The loan amount, to the extent it exceeds the policy’s cost basis (total premiums paid minus any tax-free distributions), can become taxable as ordinary income. This can occur if the growing loan balance, including unpaid interest, depletes the policy’s cash value, causing the policy to terminate.